A Q&A with Professor John Kay: “The financial sector needs reform, not regulation”

Professor John Kay is a leading British economist whose main interest is the relationship between economics and business. He is the author of several books, including last year’s Other People’s Money, which explores to what extent the financial services sector currently serves the needs of the final users of financial services, distinct from market participants, and what can be done to try and make sure it does that job better in the future. Professor Kay will deliver the 2016 Joan Muysken lecture in Maastricht on 11 April.

Your most recent book, Other People’s Money, is rather critical of the current culture and working structure of the financial sector. How has it been received within the financial world?The book is a response to the 2008 crisis that says that the source of the problems in the industry go much deeper than things that went wrong with subprime mortgages in the United States in 2005-2006. And it’s been received well, almost to a point that depresses me, because what I’m providing is a pretty critical message. But actually, particularly among asset managers, there’s an extensive feeling of, “we would like to be doing a different and better job, but we’re constrained from doing so by a mixture of client expectations and regulation,” and I think that’s largely true. It’s very difficult for individuals or groups of individuals to change the culture.

What, ultimately, should the core function of the financial sector be? What purpose should it serve?As far as I’m concerned, finance should basically do four things: provide a payment system; enable us to smooth our consumption over our lifetime; undertake capital allocation; and help us mitigate risks. Particularly in relation to the third and fourth of these things, which are what the wholesale financial markets are more concerned with, it’s drifted a long way from these fundamental purposes in what is largely a self-referential way. So what people call “capital allocation” is in fact very largely the trading of assets that already exist in secondary markets. And what is called “risk mitigation” is actually mitigation of risks that were created within the financial services sector itself. And actually not very successful mitigation at that, which we saw from not just the 2008 crisis, but the Eurozone crisis equally.

And in what ways has the financial sector strayed from these core responsibilities?What a finance sector does today, to a very large extent, is to trade with itself. That is what most people in wholesale financial services do. And we’ve created a very large superstructure of intermediation in which transactions and trading have essentially replaced relationships as the drivers of financial transactions in ways that have not improved and in some respects have made worse the services that are being provided to businesses and households.

You write that the financial sector needs reform, not regulation. Why hasn’t regulation brought about the change you’d like to see?We try to regulate by imposing more and more prescriptive rules. And this is a route that has not really succeeded in any industry and will not succeed here. What you end up doing is writing rules which can never cover all the contingencies that could be envisaged. People then devise ways to get around them. You complicate the rules still further, or you respond to unintended consequences by elaborating the rules and it’s simply a never-ending process. And you end up with what I believe we have today, which is rulebooks that are immensely detailed and in a sense intrusive and not very useful at serving the needs of the real underlying users of finance.

What level of reform do you see is needed, and have you observed any signs of impactful change since 2008?I have seen very little change since 2008, and almost none in terms of the fundamental issues. It’s partly a matter of cultural change, we need that, and it’s also a matter of structural change in the industry. To move away from financial conglomerates. To separate retail banking—the business of deposit taking and lending on mortgages—from investment banking, which is largely about trading and secondary assets. To separate within investment banking the various functions of advising corporations, of issuing securities, of managing assets for other people, and trading on the banks’ own accounts. These are all activities that in my view conflict with each other and which ought to be better done by specialist institutions as profitability relates more to users’ needs than to intra-sector trading.